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A Case Study
The Federal Reserve
Monetary Policy
Date of Announcement
December 13, 2005
Date of next Federal Open Market Committee Meeting
January 31, 2006
Reasons for a Case Study on the Federal Open Market Committee
Following Federal Open Market Committee announcements, newspapers
across the country have front-page stories about Federal Reserve actions to
change the target for interest rates and to either boost spending and employment
in the U.S. economy or to slow growth in spending. Attention increased as the
economy entered a recession in 2001 and then increased again when the Federal
Open Market Committee began a series of increases in the target for its federal
funds rate in an effort to reduce the stimulus. The announcements reflect serious
concerns with the state and direction of the economy and the resulting policy
actions.
This case study is intended to guide students and teachers through an analysis
of the actions the Federal Reserve began to take last year in an effort to reduce the
amount of stimulus that it had been providing the economy. An understanding of
monetary policy in action is fundamental to developing a thorough understanding
of macroeconomics and the U.S. economy.
Notes to Teachers
The material in this case study in italics is not included in the student version.
This initial case study of the semester introduces relevant concepts and issues.
Subsequent case studies following FOMC announcements will describe the
announcement and add concepts and complexity throughout the semester. (Slides
showing each paragraph of the announcement are included in the accompanying
PowerPoint slides.)
Federal Open Market Committee (FOMC)
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The primary function of the FOMC is to direct monetary policy for the U.S.
economy. The FOMC meets about every six weeks. (The next meeting is
January 31, 2006.) The seven Governors of the Federal Reserve Board and five
of the twelve Presidents of the Federal Reserve Banks make up the committee.
The staff of the Federal Reserve implements the recommended policies.
The seven members of the Board of Governors are appointed by the President
and confirmed by the Senate to serve 14-year terms of office. Members may serve
only one full term, but a member who has been appointed to complete an
unexpired term may be reappointed to a full term. The President designates, and
the Senate confirms, two members of the Board to be Chairman and Vice
Chairman of the Federal Reserve, for four-year terms.
The seven Board members constitute a majority of the 12-member FOMC, the
group that makes the key decisions regarding monetary policy. The other five
members of the FOMC are Reserve Bank presidents, one of whom is always the
president of the Federal Reserve Bank of New York. The other Bank presidents
serve one-year terms on a rotating basis. Traditionally, the Chairman of the Board
of Governors serves as the Chairman of the FOMC.
Announcement
The Federal Open Market Committee decided today to raise its target
for the federal funds rate by 25 basis points to 4-1/4 percent.
Despite elevated energy prices and hurricane-related disruptions, the
expansion in economic activity appears solid. Core inflation has stayed
relatively low in recent months and longer-term inflation expectations
remain contained. Nevertheless, possible increases in resource
utilization as well as elevated energy prices have the potential to add to
inflation pressures.
The Committee judges that some further measured policy firming is
likely to be needed to keep the risks to the attainment of both
sustainable economic growth and price stability roughly in balance. In
any event, the Committee will respond to changes in economic prospects
as needed to foster these objectives.
Voting for the FOMC monetary policy action were: Alan Greenspan,
Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger
W. Ferguson, Jr.; Richard W. Fisher; Donald L. Kohn; Michael H.
Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
In a related action, the Board of Governors unanimously approved a
25-basis point increase in the discount rate to 5-1/4 percent. In taking
this action, the Board approved the requests submitted by the Boards of
Directors of the Federal Reserve Banks of Boston, New York,
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Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis,
Minneapolis, Kansas City, Dallas, and San Francisco.
The complete press release is available at:
http://www.federalreserve.gov/boarddocs/press/monetary/2005/20051213/
Interactive exercise:
Does this announcement signal a change in monetary policy or a continuation
of recent policy?
A change
A continuation
Responses:
To “A change”: No, this is a continuation of increases in the target
federal funds rate that has been occurring since the June 2004
meeting.
To “A continuation”: Yes, that is correct. This is a continuation of
increases in the target federal funds rate that has been occurring since
the June 2004 meeting.
Does this announcement signal a change in efforts to encourage growth in
spending in the economy or is it more likely an attempt to reduce such
encouragement?
To encourage
growth
To reduce
growth
Responses:
To “To encourage growth”: No, that is incorrect. It is believed that
current interest rate levels are encouraging growth in spending and
there is no longer a need to do so.
To “To reduce growth”: Yes, that is correct. It is believed that
current interest rate levels are encouraging growth in spending and
there is no longer a need to do so.
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Guide to the Announcement
The Federal Open Market Committee has increased the target for its federal
funds rate at each of its meetings since June 2004.
The first paragraph of the announcement summarizes the current monetary
policy changes - this month it is the decision to increase the target federal funds
rate for the thirteenth meeting in a row - increasing the target from 4.00 percent to
4.25 percent.
The language used to describe the increase assumes an understanding the
definition of a basis point. There are 100 basis points in one percent of interest.
Thus, an increase of 25 basis points is equal to one-quarter of one percent.
In the second and third paragraphs, the reasoning behind the decision is
presented.
In the second paragraph, reference is made to negative economic effects of the
damage done by the hurricanes in the southeastern part of the U.S. and by the
high oil prices. Yet, the committee believes the economy continues to expand.
The members are not currently concerned with inflationary pressure. However,
the economy has faced higher energy prices and may be approaching a higher
utilization of its capacity – both of which may increase inflationary pressures in
the future.
In the third paragraph, the committee indicates that the risks are balanced
between inflation (“price stability”) and sustainable economic growth. This
means that the chances of increased inflation and chances of a slowdown in the
economic growth are about equal. However, in order to maintain that balance, the
committee believes that it will need to continue its increases in the target federal
funds rate in the future. The term measured has been interpreted to mean gradual
increases – for example, ¼ of a percent.
The final sentence in the third paragraph is added simply to reassure analysts
that if expectations of inflation change, the FOMC will change its policy quickly
and increase the target for the federal funds rate more rapidly. If increased
inflationary pressure appear, the FOMC is likely to increase the target federal
funds rate more rapidly. If growth in spending in the economy were to slow, the
FOMC would be likely to decrease the target.
The fourth paragraph describes the votes of the FOMC members on changing
the target for the federal funds rate. In the past, there has been a lag between the
announcement of the policy and the publication of this information about votes.
This change, which was implemented a little over two years ago, is one step in a
FOMC trend toward releasing more information immediately following their
meetings. All members of the FOMC voted to leave the target federal funds rate
unchanged.
The Federal Reserve Board of Governors actually sets another interest rate
known as the discount rate. This is the focus of the fifth paragraph. The process
is one of approving requests for a change received from the twelve Federal
Reserve Banks. In this announcement, the discount rate is increased by ¼ of one
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percent to a level of 5 percent. More discussion of the discount rate follows
below.
Data Trends
The FOMC used policies actively throughout much of the 1990s. The FOMC
had lowered the target federal funds rate in a series of steps beginning in July of
1990 until September of 1992, all in response to a recession beginning in July of
1990 and ending in March of 1991. See the first figure showing changes in the
target. (The periods of the 1990-1991 recession and the 2001 recession are shown
in gray on the graph.)
Federal Funds Rate Graph
Then as inflationary pressures began to increase in 1994, the Federal Reserve
began to raise rates. In response to increased inflationary pressures once again in
1999, the Federal Reserve raised rates six times from June 1999 through May of
2000. Those changes are obvious in the graph.
Growth began to slow at the end of 2000. The slowing growth was one
indication of the need for a change in monetary policy that would boost spending
in the economy. The FOMC responded by cutting the target federal funds rate
throughout the year.
Then as the economy began to recover from the recession and the FOMC
turned to concerns that the economy did not need as much stimulation, a series of
“measured” increases in the target were undertaken and are continuing with the
current increase.
Tools of the Federal Reserve
The Federal Reserve buys and sells bonds and by doing so, increases or
decreases banks' reserves and banks’ abilities to make loans. As banks increase
or decrease loans, the nation's money supply increases or decreases. That, in turn,
decreases or increases interest rates. The purchase and sale of bonds by the
Federal Reserve is called open market operations. The Federal Reserve is
“operating”, that is buying or selling, in the “open market” for U.S. Treasury
securities.
When the Federal Reserve sells a bond, an individual or institution buys the
bond with a check on their account and gives the check to the Federal Reserve.
The Federal Reserve removes an equal amount from the customer’s bank’s
reserves. The bank, in turn, removes the same amount from the customer’s
account. Thus, the money supply shrinks. The opposite occurs when the Federal
Reserve buys a bond. The Federal Reserve gives a check to the seller of the bond.
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The seller deposits the check in their account. Their bank adds to the amount to
the deposits and thus the money supply increases. The bank also presents the
check back to the Federal Reserve, which in turn adds the amount to the bank’s
reserves. Because the bank has to keep only a portion of those reserves, the bank
makes loans with the remainder. Thus the money supply expands even further.
As banks attempt to make more loans, interest rates fall.
Open market operations are the primary tool of the Federal Reserve. It is a
tool that is often used and is quite powerful. This is what the Federal Reserve
actually does when it announces a new target for its federal funds rate. The
federal funds rate is the interest rate banks charge one another in return for a loan
of reserves. If the supply of reserves is reduced because the Federal Reserve has
sold bonds, that interest rate is likely to increase. If the supply of reserves is
increased because the Federal Reserve has purchased bonds, that interest rate is
likely to decrease.
Banks earn profits by accepting deposits and lending part of those deposits to
someone else. They sometimes charge fees for establishing and maintaining
accounts and always charge borrowers an interest rate. Banks are required by the
Federal Reserve System to hold reserves in the form of currency in their vaults or
deposits with Federal Reserve System.
The Federal Reserve also has two other tools that may be used to influence the
expansion of and contraction in the money supply.
The Discount Rate
The discount rate is the interest rate the Federal Reserve charges banks if
banks borrow reserves from the Federal Reserve itself. Banks may need to
borrow reserves if they have made too many loans, have experienced withdrawals
of deposits or currency, or have had fewer deposits than they expected.
In reality, banks seldom borrow reserves from the Federal Reserve and tend to
rely more on borrowing reserves from other banks when they are needed. They
will still pay an interest rate (the federal funds rate), but that is a rate determined
in the market for reserves and influenced by the open market operations of the
Federal Reserve.
The discount rate is most often changed along with the target for the federal
funds rate, but the discount rate change does not have a very important effect as
so few banks actually use that means of borrowing reserves. In this
announcement, the discount rate is increased along with the federal funds rate.
Figure 2 shows the discount rate along with the federal funds rate. Notice that
the discount rate typically changes along with the target for the federal funds rate.
Prior to 2003, the discount rate was below the target federal funds rate. Since then
the discount rate has been one percent above the target federal funds rate. That is
an additional reason that there is little current borrowing of reserves directly from
the Federal Reserve.
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Federal Funds Rate and Discount Rate Graph
Reserve Requirements
Banks are required to hold a portion of some of their deposits in reserves. The
portion varies depending upon the type of deposits and the size of the bank. Most
are required to have either 3 or 10 percent of their deposits on reserve. Reserves
consist of the amount of currency that a bank holds in its vaults and the bank’s
deposits at Federal Reserve banks.
If banks have more reserves than they are required to have, they can increase
their lending. If they have insufficient reserves, they have to curtail their lending
or borrow reserves from the Federal Reserve or from another bank that may have
extra, or what are called excess, reserves. The reserve requirement is seldom
changed, but it has a potentially very large effect on the ability to make loans and
thus on interest rates.
For more background on the Federal Reserve and resources to use in the
classroom, go to www.federalreserve.gov.
How does Monetary Policy Work?
Monetary policy works by affecting the amount of money that is circulating in
the economy, the level of interest rates, and changes in spending. The Federal
Reserve can change the amount of money that banks are holding in reserves by
buying or selling existing U.S. Treasury bonds. When the Federal Reserve buys a
bond, the seller deposits the Federal Reserve’s check in her bank account. The
bank’s deposits and reserves increase. The bank then has an increased ability to
make loans, which in turn will increase the amount of money in the economy.
Competition among banks forces interest rates down as banks compete with
one another to make more loans. If businesses are able to borrow more to build
new stores and factories and buy more computers, machines, and tools, total
spending increases. Consumer spending that partially depends upon levels of
interest rates (automobile and appliances, for example) is also affected. Output
and employment. In this case, unemployment will fall. There may also be some
upward pressure on prices.
When the Federal Reserve adopts a restrictive monetary policy, it sells bonds
in order to reduce the money supply. This results in higher interest rates and less
spending. A restrictive monetary policy will decrease inflationary pressures, but
it may also decrease investment spending and real gross domestic product. See
the Inflation Case Study for a more detailed discussion of inflation.
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Interactive questions –
1. If the FOMC is concerned about rising inflation, it would likely:
Expand the money supply
Contract the money supply
Pop up:
No, the correct answer is
to reduce the money
supply
If first box, then –
If second box, then –
Yes, the correct answer is
to reduce the money
supply
2. If the FOMC is concerned about increasing future unemployment, it would
likely:
Purchase bonds
Sell bonds
Pop up:
If first box, then –
Yes, the correct answer is
to purchase bonds in order
to increase the money
supply
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If second box, then –
No, the correct answer is
to purchase bonds in order
to increase the money
supply
3. If the FOMC is concerned about spending that is growing too rapidly, it
would likely:
Raise its target for the
federal funds rate
Lower its target for the
federal funds rate
Pop up:
If first box, then –
If second box, then –
Yes, the correct answer is
to increase the target
federal funds rate by to
selling bonds in order to
decrease the money
supply
No, the correct answer is
to increase the target
federal funds rate by to
selling bonds in order to
decrease the money
supply
Other tools
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1. If the Federal Reserve wishes to slow the economy in order to decrease
spending, which of the following actions is appropriate?
Raise the
discount rate
Decrease the
discount rate
If the answer chosen is the first box, then –
Yes, that is correct. That will
discourage bank borrowing and thus
lead to slowing growth in the money
supply
If the answer chosen is the second box, then –
No, that is not correct.
A decrease will encourage bank
borrowing and thus lead to rising
growth in the money supply
2. If the Federal Reserve wishes to stimulate the economy in order to increase
spending, which of the following actions is appropriate?
Raise the
discount rate and
lower the
required reserve
ratio
Raise the
discount rate and
raise the required
reserve ratio
Decrease the
discount rate and
lower the
required reserve
ratio
Decrease the
discount rate and
increase the
required reserve
ratio
If the answer is the third box, then –
Yes, that is correct. Both actions will
increase the money supply and cause
interest rates to fall and spending to
rise.
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If the answer chosen is the first, second, or fourth box, then –
No, that is not correct. Think about
how each policy will affect the money
supply and then interest rates. Try
again.
Comparison of Monetary and Fiscal Policy
The FOMC reacts to a slowing economy by expanding the money supply,
lowering interest rates, and creating increased spending. The reaction to
increasing inflationary pressures is to decrease the money supply, raise interest
rates, and thereby slowing growth in spending.
Fiscal policy is the taxing and spending policies of the federal government.
Those policies also have the potential to influence economic conditions whether
deliberately or as an unintended consequence. If the economy is entering a
recession, fiscal policy response might be to increase government spending and to
lower taxes. If spending in the economy is growing too rapidly, the fiscal
response might be to decrease government spending and to increase taxes.
In those processes, there will be debates in Congress about what to do with
spending and taxes in order to stimulate or slow overall spending in the economy.
These debates normally take a substantial amount of time. This lag points to one
of the key differences between fiscal and monetary policy. Fiscal policy is much
more difficult to implement but once the decision is made, it takes effect quickly.
Monetary policy decisions are much easier to institute and more responsive to
economic conditions, but actually take longer to change spending once the
decision is made.
QUESTIONS
1. What are the Federal Reserve current observations and concerns?
2. What tool will the Federal Reserve use to accomplish its goals?
3. If the Federal Reserve were to become concerned about a slowing of the
economic expansion, what is it likely to do with its open market operations
and the federal funds rate?
4. How do changes in monetary policy affect your family’s spending and
business spending in the economy?
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Answers to Questions
1. The Federal Reserve believes that the economy is growing without significant
inflationary pressure. It goal is to remove the stimulative pressure created by
low interest rates. It is implying that it will continue the gradual increases in
the target of the federal funds rate.
2. The Federal Reserve can buy or sell U.S. Treasury bonds, which in turn will
lower or increase the federal funds rate. To reduce the stimulative effects of
recent policy, the FOMC is increasing the target for the federal funds rate.
That means that the Federal Reserve is selling bonds. (Or it means that the
Federal Reserve is slowing the growth of the money supply by purchasing
fewer bonds.)
3. The Federal Reserve would purchase more bonds to expand the money supply
and bank reserves and that would lower the federal funds rate. The goal
would be to increase overall spending in the economy.
4. If the Federal Reserve is purchasing bonds, banks will have greater reserves
due to increased deposits. With the increased reserves, they can increase the
number and size of loans. The increase in loans and the resulting lower
interest rates encourage business (and consumer) borrowing and spending.
The increased spending in the economy should result in increased business
production and employment.
Key Concepts
Discount rate
Federal funds rate
Federal Open Market Committee
Federal Reserve System
Fiscal policy
Interest rates
Monetary policy
Open market operations
Reserve requirements
Relevant National Economic Standards
11. Money makes it easier to trade, borrow, save, invest, and compare the
value of goods and services. Students will be able to use this knowledge to
explain how their lives would be more difficult in a world with no money,
or in a world where money sharply lost its value.
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12. Interest rates, adjusted for inflation, rise and fall to balance the
amount saved with the amount borrowed, which affects the allocation of
scarce resources between present and future uses. Students will be able to
use this knowledge to explain situations, in which they pay or receive
interest, and explain how they would react to changes in interest rates if
they were making or receiving interest payments.
15. Investment in factories, machinery, new technology and in the health,
education, and training of people can raise future standards of living.
Students will be able to use this knowledge to predict the consequences of
investment decisions made by individuals, businesses, and governments.
16. There is an economic role for government in a market economy
whenever the benefits of a government policy outweigh its costs.
Governments often provide for national defense, address environmental
concerns, define and protect property rights, and attempt to make markets
more competitive. Most government policies also redistribute income.
Students will be able to use this knowledge to identify and evaluate the
benefits and costs of alternative public policies, and assess who enjoys the
benefits and who bears the costs.
18. A nation's overall levels of income, employment, and prices are
determined by the interaction of spending and production decisions made
by all households, firms, government agencies, and others in the economy.
Students will be able to use this knowledge to interpret media reports
about current economic conditions and explain how these conditions can
influence decisions made by consumers, producers, and government policy
makers.
19. Unemployment imposes costs on individuals and nations. Unexpected
inflation imposes costs on many people and benefits some others because
it arbitrarily redistributes purchasing power. Inflation can reduce the rate
of growth of national living standards because individuals and
organizations use resources to protect themselves against the uncertainty
of future prices. Students will be able to use this knowledge to make
informed decisions by anticipating the consequences of inflation and
unemployment.
20. Federal government budgetary policy and the Federal Reserve
System's monetary policy influence the overall levels of employment,
output, and prices. Students will be able to use this knowledge to
anticipate the impact of federal government and Federal Reserve System
macroeconomic policy decisions on themselves and others.
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Sources of Additional Activities
Advanced Placement Economics: Macroeconomics. (National Council on
Economic Education)
UNIT FOUR: Money, Monetary Policy, and Economic Stability
UNIT FIVE: Monetary and Fiscal Combinations: Economic Policy
in the Real World
Entrepreneurship in the U.S. Economy--Teacher Resource Manual
LESSON 10: The Nature of Consumer Demand
LESSON 11: What Causes Change in Consumer Demand?
LESSON 19: Financing the Entrepreneurial Enterprise
LESSON 32: Government Policies, the Economy, and the
Entrepreneur
On Reserve: A Resource for Economic Educators from the Federal
Reserve Bank of Chicago. Number 28, April 1994: Basics to Bank
on
Economics USA: A Resource Guide for Teachers
LESSON 11: The Federal Reserve: Does Money Matter?
LESSON 12: Monetary Policy: How Well Does It Work?
LESSON 13: Stabilization Policy: Are We Still in Control?
Handbook of Economic Lesson Plans for High School Teachers
LESSON EIGHTEEN: The Federal Reserve System
LESSON NINETEEN: Making Monetary Policy: The Tools of the
Federal Reserve System
Focus: High School Economics
20. Money, Interest, and Monetary Policy
All are available in Virtual Economics, An Interactive Center for Economic
Education (National Council on Economic Education) or directly through the
National Council on Economic Education.
Author: Stephen Buckles
Vanderbilt University
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